Interbank Market Turmoils and the Macroeconomy

Kopiec, Pawel (2018): Interbank Market Turmoils and the Macroeconomy.

Abstract

This paper studies the macroeconomic consequences of interbank market disruptions caused by higher counterparty risk. I propose a novel, dynamic model of banking sector where banks trade liquidity in the frictional OTC market à la Afonso and Lagos (2015) that features counterparty risk. The model is then embedded into an otherwise standard New Keynesian framework to analyze the macroeconomic impact of interbank market turmoils: economy suffers from a prolonged slump and deflationary pressure during such episodes. I use the model to analyze the effectiveness of two policy measures: rise in the supply of central bank reserves and interbank market guarantees in mitigating the adverse effects of those disruptions.

• Item Type: MPRA Paper
• Language: English
• Keywords: Financial crisis, Interbank market, Policy intervention, OTC market
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

Acharya, V. V. and Skeie, D. (2011). A model of liquidity hoarding and term premia in inter-bank markets. Journal of Monetary Economics, 58(5):436–447.

Adrian, T., Colla, P., and Shin, H. S. (2012). Which Financial Frictions? Parsing the Evidence from the Financial Crisis of 2007-9. NBER Working Papers 18335, National Bureau of Economic Research, Inc.

Afonso, G., Kovner, A., and Schoar, A. (2011). Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis. Journal of Finance, 66(4):1109–1139.

Afonso, G. and Lagos, R. (2015). Trade Dynamics in the Market for Federal Funds. Econometrica, 83:263–313.

Atkeson, A. G., Eisfeldt, A. L., and Weill, P. O. (2015). Entry and Exit in OTC Derivatives Markets. Econometrica, 83:2231–2292.

Beaudry, P., Galizia, D., and Portier, F. (2014). Reconciling Hayek’s and Keynes Views of Recessions. NBER Working Papers 20101, National Bureau of Economic Research, Inc.

Bianchi, J. and Bigio, S. (2014). Banks, Liquidity Management and Monetary Policy. NBER Working Papers 20490, National Bureau of Economic Research, Inc.

Blanchard, O. and Gali, J. (2010). Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment. American Economic Journal: Macroeconomics, 2(2):1–30.

Brunnermeier, M. K. (2009). Deciphering the Liquidity and Credit Crunch 2007-2008. Journal of Economic Perspectives, 23(1):77–100.

Cui, W. and Radde, S. (2016). Money and Asset Liquidity in Frictional Capital Markets. American Economic Review, 106(5):496–502.

Flannery, M. J. (1996). Financial Crises, Payment System Problems, and Discount Window Lending. Journal of Money, Credit and Banking, 28(4):804–824.

Freixas, X. and Jorge, J. (2008). The Role of Interbank Markets in Monetary Policy: A Model with Rationing. Journal of Money, Credit and Banking, 40(6):1151–1176.

Freixas, X., Martin, A., and Skeie, D. (2011). Bank Liquidity, Interbank Markets, and Monetary Policy. Review of Financial Studies, 24(8):2656–2692.

Heider, F., Hoerova, M., and Holthausen, C. (2015). Liquidity hoarding and interbank market rates: The role of counterparty risk. Journal of Financial Economics, 118(2):336–354.

Justiniano, A., Primiceri, G. E., and Tambalotti, A. (2010). Investment shocks and business cycles. Journal of Monetary Economics, 57(2):132–145.

Lucas, R. J. (1990). Liquidity and interest rates. Journal of Economic Theory, 50(2):237–264.

Negro, M. D., Eggertsson, G., Ferrero, A., and Kiyotaki, N. (2017). The Great Escape? A Quantitative Evaluation of the Fed’s Liquidity Facilities. American Economic Review, 107(3):824–857.

Ramey, G., den Haan, W. J., and Watson, J. (2000). Job Destruction and Propagation of Shocks. American Economic Review, 90(3):482–498.

Rotemberg, J. J. (1982). Sticky Prices in the United States. Journal of Political Economy, 90(6):1187–1211.

Shi, S. (2015). Liquidity, assets and business cycles. Journal of Monetary Economics, 70(C):116–132.

Zbaracki, M. J., Ritson, M., Levy, D., Dutta, S., and Bergen, M. (2004). Managerial and Customer Costs of Price Adjustment: Direct Evidence from Industrial Markets. The Review of Economics and Statistics, 86(2):514–533.